The spread between central and state government securities has widened on account of subdued demand. Currently, the spread stands at over 60 basis points (bps) compared to 50 bps in July and 30 bps in June. With overall negative sentiment in the bond market and supply-demand mismatch led the state-borrowing costlier, said market participants. The usual spread between G-sec and state government securities ranges from 30 to 40 bps.
In the last auction on August 19, the cut-off yield on the 10-year SDL (state development loans) for Tamil Nadu was 7.09%. For comparison, cut-off yields were 6.86% in July and 6.66% in June.
“There is a huge supply of SDLs and there are no buyers in the market. The market does not see much positive cues going ahead. Therefore, we don’t find these levels comfortable to buy,” said a dealer at a state-owned bank.
“States normally borrow more in the second half compared to the first half. They have started borrowing heavily in the first half itself perhaps due to increased capex,” said Dhawal Dalal, CIO – fixed income, Edelweiss Mutual Fund. “Besides, states are issuing longer tenures bonds, pushing up the supply further on the long-end. Yield gap between different states for the same tenor is also getting wider from long-term averages.”
High inflation and fiscal uncertainty
The yield on 10-year benchmark government bonds surged to a four-month high of 6.55% in anticipation of fiscal pressures after the announcement of GST rationalisation. The government bond yields have been rising since August policy, where the high inflation projections made the market believe of no more rate cuts on the table. In August so far, yields rose 18 bps.
The weak demand in the bond market can be also attributed to reduced incremental buying from long term investors such as pension funds, insurance companies, and banks, said market participants.
A stressful outlook for H2 FY26
According to RBI, for the first half of FY26, the state government is expected to borrow close to Rs 5.6 lakh crore. So far the states have borrowed Rs 3.5 lakh crore till date. Economists expect state borrowing to be around Rs 5.2 lakh crore in the second half of the year.
With overhaul of GST slabs, market participants expect the spread to widen further. “The spread will remain under stress as investors may assess the impact of GST on individual state revenues before demand returns to normal. In H2, the supply is often elevated, in particular in Q4 state borrowings jump sharply,” said Sonal Badhan, economist, Bank of Baroda. Last year, states borrowed ~39% of the total annual borrowing in Q4. In case borrowings in H2 are higher than expected then the spread between SDLs and G-Sec will widen further, she added.